Too Big To Fail: The Hazards of Bank Bailouts

Excerpt from Too Big To Fail: The Hazards of Bank Bailouts

Editor's note: The following excerpts are from Too Big to
Fail: The Hazards of Bank Bailouts by Stern and Feldman, published by The Brookings Institution (2004) Brookings Institution Press.

Preface

In late 2001, following the tragic events of September 11, a medium-size
broker-dealer firm headquartered in Minneapolis—MJK Clearing
(MJKC)—experienced severe financial difficulty. It was alleged
to the Federal Reserve Bank of Minneapolis that the failure of MJKC
would spill over and severely impair around 200,000 retail customers,
several brokerage firms involved in the stock-lending deal that initially
caused the problems, and a variety of small brokerage houses throughout
the Midwest for which MJKC provided back-office services. MJKC's lawyer
argued that the firm was too big to fail (TBTF), that its failure
would disrupt economic activity in the Midwest, and, therefore, that
the Federal Reserve should provide assistance to it. Indeed, the leader
of a second Reserve bank in the Midwest called Minneapolis to inquire
about the possibility of spillover effects.

The largest liquidation of a securities broker
by the Securities Investor Protection Corporation was hardly
a trivial event.1 However, the initial claims of financial and economic disruption
were thought at the time, and later demonstrated, to be exaggerated,
and no assistance was provided. The fact that MJKC's well-respected
representative raised TBTF concerns shows how deeply the ethos
of creditor protection in the name of financial stability permeates
the financial environment. More important, if TBTF arguments
are advanced in a case with only a hint of regional complications,
they certainly will present themselves in almost any failure of significance. Indeed,
a local newspaper columnist and a national banking association seemed
to find examples of contagion in the MJKC failure.2Left to their own devices, policymakers could protect
creditors even when other options would prove superior and reforms
to prevent this undesirable outcome were available. Thus we viewed
the events as a warning: Too big to fail is no theoretical problem,
but rather a central public policy dilemma. This conclusion confirmed
earlier concerns.

Before the MJKC failure, in mid-2000 to be precise, we presented options
for addressing the TBTF problem at a conference held at the University
of Chicago Business School. Michael Mussa, then the research director
for the International Monetary Fund, dismissed our options out of
hand. He argued that governments cannot convince creditors of large
banks that they will take losses if their bank fails. In short, too
big to fail is an unsolvable problem. We later heard from equally
distinguished audience members that, in fact, there was not a TBTF
problem in the United States. Legislation passed in the early 1990s
had eliminated the problem, and other countries could easily adopt
the same reforms. In either case, the message was the same: Policymakers
and the public should not spend much time worrying about how to address
too big to fail.

We left the conference convinced that our previous, abbreviated work
had failed to make our case. We had not adequately conveyed how policymakers
could enact reforms that reduce creditors' expectations of a bailout.
Moreover, we had not sufficiently established that earlier legislation
had failed to fix the problem.

From such events came the impetus for a book-length treatment of the
TBTF problem as well as the book's organization. In the first part,
we warn readers that the TBTF problem is real, costly, and becoming
more severe. In the second, we provide policymakers with options to
address it. Too big to fail is not unsolvable, and this is the right
time to address the problem—waiting for the next banking crisis
can hardly improve our lot. ...

... The views in this book are not necessarily those of the Federal
Reserve Bank of Minneapolis or the Federal Reserve System.

1Securities
Investor Protection Corporation, "2001 Set Record for Number
of Customers Paid, Amount of Advances," news release, March
13, 2002.

Introduction: Our Message and Methods

Summarizing the warnings and options of this book requires a little
background for the uninitiated. We start with the trivial observation
that banks fail.1Some
banks fail without notice. Other failing banks capture the attention
of policymakers, often because of the bank's large size and significant
role in the financial system. Determining the appropriate policy response
to an important failing bank has long been a vexing public policy
issue. The failure of a large banking organization is seen as posing
significant risks to other financial institutions, to the financial
system as a whole, and possibly to the economic and social order.
Because of such fears, policymakers in many countries—developed
and less developed, democratic and autocratic—respond by protecting
uninsured creditors of banks from all or some of the losses they otherwise
would face. These banks have assumed the title of "too big to
fail" (TBTF),2a
term describing the receipt of discretionary government support by
a bank's uninsured creditors who are not automatically entitled to
government support (for simplicity we use creditors and uninsured
creditors synonymously from here on).3

To the extent that creditors of TBTF banks expect government protection,
they reduce their vigilance in monitoring and responding to these
banks' activities. When creditors exert less of this type of market
discipline, the bank may take excessive risks. TBTF banks will make
loans and other bets that seem quite foolish in retrospect. These
costs sound abstract but are, in fact, measured in the hundreds of
billions of dollars of lost income and output for countries, some
of which have faced significant economic downturns because of the
instability that too big to fail helped to create. This undesirable
behavior is frequently referred to as the "moral hazard"
of TBTF protection. Such behavior wastes resources.

Our Message

Despite some progress, our central warning is that not enough
has been done to reduce creditors' expectations of TBTF protection.
Many of the existing pledges and policies meant to convince creditors
that they will bear market losses when large banks fail are not credible
and therefore are ineffective. Blanket pledges not to bail out creditors
are not credible because they do not address the factors that motivate
policymakers to protect uninsured bank creditors in the first place.
The primary reason why policymakers bail out creditors of large banks
is to reduce the chance that the failure of a large bank in which
creditors take large losses will lead other banks to fail or capital
markets to cease working efficiently.

Other factors may also motivate governments to protect uninsured creditors
at large banks. Policymakers may provide protection because doing
so benefits them personally, by advancing their career, for example.
Incompetent central planning may also drive some bailouts. Although
these factors receive some of our attention and are addressed by some
of our reforms, we think they are less important than the motivation
to dampen the effect of a large bank failure on financial stability.

Despite the lack of definitive evidence on the moral hazard costs
and benefits of increased stability generated by TBTF protection,
the empirical and anecdotal data, analysis, and our general impression—imperfect
as they are—suggest that TBTF protection imposes net costs. We also argue that the TBTF problem has grown in severity.
Reasons for this increase include growth in the size of the largest
banks, greater concentration of banking system assets in large banks,
the greater complexity of bank operations, and, finally, several trends
in policy including a spate of recent bailouts.

Our views are held by some, but other respected analysts come to different
conclusions. Some observers believe that the net costs of TBTF protection
have been overstated, while others note that some large financial
firms have failed without their uninsured creditors being protected
from losses. However, even analysts who weigh the costs and benefits
differently than we do have reason to support many of our reforms.
Some of our recommendations, for example, make policymakers less likely
to provide TBTF protection and address moral hazard precisely by reducing
the threat of instability. Moreover, our review of cases where bailouts
were not forthcoming suggests that policymakers are, in fact, motivated
by the factors we cite and that our reforms would push policy in the
right direction.

A second camp believes that TBTF protection could impose net costs
in theory, but in practice legal regimes in the United States—which
other developed countries could adopt—make delivery of TBTF
protection so difficult as to virtually eliminate the TBTF problem.

We are sympathetic to the general and as yet untested approach taken
by U.S. policymakers and recognize that it may have made a dent in
TBTF expectations. In the long run, however, we predict that the system
will not significantly reduce the probability that creditors of TBTF
banks will receive bailouts. The U.S. approach to too big to fail
continues to lack credibility.

Finally, a third camp also recognizes that TBTF protection could impose
net costs but believes that there is no realistic solution. This camp
argues that policymakers cannot credibly commit to imposing losses
on the creditors of TBTF banks. The best governments can do, in their
view, is accept the net costs of TBTF, albeit with perhaps more resources
devoted to supervision and regulation and with greater ambiguity about
precisely which institutions and which creditors could receive ex
post TBTF support.

Like the third camp, we believe that policymakers face significant
challenges in credibly putting creditors of important banks at risk
of loss. A TBTF policy based on assertions of "no bailouts ever"
will certainly be breached. Moreover, we doubt that any single policy
change will dramatically reduce expected protection. But fundamentally
we part company with this third camp. Policymakers can enact a
series of reforms that reduce expectations of bailouts for many creditors
at many institutions. Just as policymakers in many countries
established expectations of low inflation when few thought it was
possible, so too can they put creditors who now expect protection
at greater risk of loss.

The first steps for credibly putting creditors of important financial
institutions at risk of loss have little to do with too big to fail
per se. Where needed, countries should create or reinforce the rule
of law, property rights, and the integrity of public institutions.
Incorporating the costs of too big to fail into the policymaking process
is another important reform underpinning effective management of TBTF
expectations. Appointment of leaders who are loath to, or at least
quite cautious about, providing TBTF bailouts is also a conceptually
simple but potentially helpful step. Better public accounting for
TBTF costs and concern about the disposition of policymakers could
restrain the personal motivations that might encourage TBTF protection.

With the basics in place, policymakers can take on TBTF expectations
more credibly by directly addressing their fear of instability. We
recommend a number of options in this regard. One class of reforms
tries to reduce the likelihood that the failure of one bank will spill
over to another or to reduce the uncertainty that policymakers face
when confronted with a large failing bank. These reforms include,
among other options, simulating large bank failures and supervisory
responses to them, addressing the concentration of payment system
activity in a few banks, and clarifying the legal and regulatory framework
to be applied when a large bank fails.

Other types of reforms include reducing the losses imposed by bank
failure in the first place and maintaining reforms that reduce the
exposure between banks that is created by payments system activities.
These policies can be effective, in our view, in convincing public
policymakers that, if they refrain from a bailout, spillover effects
will be manageable. Such policies therefore encourage creditors to
view themselves at risk of loss and thus improve market discipline
of erstwhile TBTF institutions.

We are less positive about other reforms. A series of reforms that
effectively punish policymakers who provide bailouts potentially also
could address personal motivational factors. However, we are not convinced
that these reforms are workable and believe that they give too much
credence to personal motivations as a factor to explain bailouts.
The establishment of a basic level of supervision and regulation (S&R)
of banks should help to restrict risk-taking, although we view S&R
as having important limitations.

Finally, policymakers have a host of other available options once
they have begun to address too big to fail more effectively. For example,
policymakers could make greater use of discipline by creditors at
risk of loss. Bank supervisors could rely more heavily on market signals
in their assessment of bank risk-taking. Deposit insurers could use
similar signals to set their premiums.

One may agree with our arguments in concept but find them lacking
in real-world pragmatism or realpolitik. A compelling case for relying
on analytical rather than political principles in addressing the failure
of large banks was made nearly thirty years ago—a full decade
before the term too big to fail became commonplace:

To many practical people the suggestion that a large bank
be allowed to fail may seem to represent dogmatic adherence to standard
economic doctrine, a victory of ideology over pragmatic common sense.
A pragmatic position is to argue that, yes, business failures do serve
a useful function, but in the specific case of a large bank, the costs
of allowing failure outweigh the costs of supporting it. After all,
the social costs of failure are immediate, while the advantages of
permitting failure are indirect and removed into the future. But this
pragmatic position should be rejected because it ignores externalities
over time. If we prop up a large bank because the direct costs of
doing so outweigh the cost of allowing it to fail, then the next time
a large bank is in danger of failing it is likely to be propped up
too. But in the future the same benefit will then probably be accorded
to medium-sized banks. And from there it is likely to spread to small
banks, to other financial institutions, and ultimately to other firms.
When one includes the cost of moving down this slippery slope in the
cost of saving a large bank, then the costs of allowing it to fail
may seem small by comparison. At a time when devotion to pragmatism
is so much in the air, it is useful to consider also the benefits
of sticking to one's principles even in hard cases.4 ...

Our Methods

... In terms of audience, we intend this book to help the wide range
of staff practitioners, as well as the policymakers they support,
to confront the TBTF problem. Although such an audience has a growing
appreciation for concepts like moral hazard and the reasoning of economists,
it is unlikely to find a treatment of the relevant issues that is
suitable for academic journals to be approachable or convincing. Instead,
it is likely to value clarity, concreteness, and conclusions that
can be internalized. ...

... The truth, as demonstrated by rigorous analysis and derived through
consensus, does not exist when it comes to many of the issues related
to too big to fail. For some issues, the relevant data have not been
collected and perhaps cannot easily be collected in any reasonable
time period. For example, there is no comprehensive list of countries
in which uninsured creditors of banks have received government protection.
Records describing the size and type of bailouts that creditors have
received are not readily available. Simply put, the basic facts are
elusive. More generally, data on and applied analysis of too big to
fail are made quite difficult by the implied nature of the support.
To be sure, some data have been collected and some analysis completed.
Such work is often based on an after-the-fact review of a single event
with real limitations because of a lack of scientific controls. There
is also theoretical work, but it often abstracts so far from institutional
detail as to provide little guidance. These models do not let policymakers
know if they should support creditors of one large bank but not another.

As a result, the environment for policymakers is characterized by
opaqueness and uncertainty. Policymakers and their staffs could wait
until a long-term research program is complete before they take action.
Acting today with sub-par information could actually make things worse,
and history is replete with such cases. But waiting for a final answer
does not seem realistic to us. A recent conference on the Great Depression
revealed strong disagreement on the underlying causes of an event
that is more than seventy years old.5

Policymakers frequently play the role of emergency room doctor. Their
actions should be informed by basic research, but they cannot wait
for final results from exhaustive laboratory experiments before operating.
Given that policymakers will often act sooner rather than later, it
seems reasonable to try to take the best available information and
combine it with economic reasoning that has passed the tests of time
and experience. We hope the result assists staff and policymakers
sort through the options that await them in triage. ...

1 We
use the term "bank" broadly to describe depositories whose
liabilities are backed by implicit and explicit government support
as well as their holding companies. 2 Although TBTF terminology
has been applied to nonfinancial firms and subnational governments,
we focus on banks and explain this decision in chapter 2.3 Too big to fail
is a misleading term in several ways—which we describe in chapter
2—but we continue to use it because it is established in the
policy debate. 4 Mayer, Thomas.
1975. "Should Large Banks Be Allowed to Fail?" Journal
of Financial and Quantitative Analysis 10 (November): 603-10.5 Fettig, David. 2000.
"Something Unanticipated
Happened: Telling Some 'Neo' Stories about the Great Depression of
the 1930s." Federal Reserve Bank of Minneapolis Region 14 (December): 19-21, 44-47. Rolnick, Arthur J. 1999.
“In This Issue.” Federal Reserve Bank of Minneapolis Quarterly Review 23
(Winter): 1.

Chapter 14

Summary: Talking Points on Too Big to Fail

We began the volume with a summary of our arguments and an identification
of our target audience, namely policymakers, their staffs, and other
professionals seeking to influence policy. We hope that these professionals
convey our main points to their bosses and clients and that the bosses
and clients internalize our story. At the risk of trivializing the
process, convincing higher-ups these days requires short oral briefings,
PowerPoint presentations, or summary memos. To help with those communications
and recognizing that a reader probably does not want or need a traditional
summary at this point, we list some talking points on too big to fail.

Three Bottom Lines

First, the TBTF problem has not been solved, is getting worse, and
leads, on balance, to wasted resources.

Second, although expectations of bailouts by uninsured creditors at
large banks cannot be eliminated, they can be reduced and better managed
through a credible commitment to impose losses: policymakers can establish
credible commitments by addressing and reducing the motivation for
bailouts.

Third, although other reforms could help to establish a credible commitment,
policymakers should give highest priority to reforms limiting the
chance that one bank's failure will threaten the solvency of other
banks.

We now provide supporting points for these conclusions.

The Problem

Even though they are not entitled to government protection, uninsured
creditors of a large or systemically important bank believe they
will be shielded from at least part of the loss in the event of
bank failure.

Anticipation of government protection warps the amount and pricing
of funding that creditors provide a TBTF bank, which, in turn, leads
banks to take excessive risk and make poor use of financial capital.
The costs of poor resource use resulting from TBTF guarantees appear
to be quite high. We believe these costs exceed the benefits of
TBTF coverage in most cases, but even those who weigh the costs
and benefits differently should be able to support many of our reforms.

Expectations of TBTF coverage have likely grown and become more
strongly held because more banks are now "large" and
because a smaller group of banks controls a greater share of banking
assets and provides key banking services. In addition, banks have
become increasingly complex, making it more difficult for policymakers
to predict the fallout from bank failure and to refuse to provide
subsequent coverage to uninsured creditors.

Reforms over the last decade aiming to limit TBTF protection,
including those adopted in the United States, are unlikely to be
effective in the long run (although they have yet to be tested and
may have made a dent in TBTF expectations).

Commitment as the Solution

In order to change the expectations of bailouts, policymakers
must convince uninsured creditors that they will bear losses when
large banks fail; changes in policy toward the uninsured must involve
a credible commitment.

A credible commitment to impose losses must be built on reforms
directly reducing the incentives that lead policymakers to bail
out uninsured creditors.

Reforms that forbid coverage for the uninsured are not credible
because they do not address underlying motivations and are easily
circumvented.

Policymakers have considerable experience in establishing credible
commitments in the setting of monetary policy. The experience of
monetary policy over the last two decades demonstrates the feasibility
of reducing long-held expectations, such as those likely held by
uninsured creditors of large banks.

Specific Motivations and Reforms

The most important motivation for bailouts is to prevent the
failure of one bank from threatening other banks, the financial
sector, and overall economic performance. To reduce that motivation,
we recommend that policymakers in developed countries take three
general steps: Enact policies and procedures that would reduce their
uncertainty about the potential for spillovers; implement policies
that directly limit creditor losses or allocate losses such that
market discipline increases without an excessive increase in instability;
consider or follow up on payments system reforms that reduce the
threat of spillovers.

Reforms that reduce policymaker uncertainty include the following:
Increase supervisory planning for, and simulation of, a large bank
failure; undertake targeted efforts that reduce the likelihood and
cost of failure for banks dominating payment markets; make legal
and regulatory adjustments that clarify the treatment of bank creditors
at failure; and provide liquidity more rapidly to uninsured creditors.

Reforms that could address concerns of excessive creditor loss
include the following: close institutions before they can impose
large losses; require banks in a weak position to increase the financial
cushion to absorb losses; impose rules that require creditors to
absorb at least some loss when their bank fails (for example, requiring
coinsurance); and allow for select coverage of the nominally uninsured
while, in general, making it more likely that creditors will suffer
losses.

Although payments system reforms are quite complex in implementation,
they are fairly straightforward in concept. One type of reform would
eliminate or significantly limit the amount that banks owe each
other through the payments system. A second type of reform would
establish methods by which a bank owed funds by a failing institution
could offset losses (for example, by seizing collateral).